AI Jenga

 A visual representation of AI finance…

The Gulf's Other Product

 We all know that the Gulf exports massive amounts of crude oil, refined products, LNG, fertilizer, helium, aluminum - and they all have to pass through the Strait of Hormuz, currently shut tight due to the Iran War. But, this is a blog about money...

Apropos, there is something else that the Gulf States export in massive quantities: Investment capital, ie money.  How much? It's not easy to calculate precisely since the countries in question tend to be secretive in their dealings. However, we do know this: they have Sovereign Wealth Funds (SWF), loosely modeled after Norway's own fund. How big are they? Here is a chart of the world's lagest SWFs by asset size.

Sovereign Wealth Fund Assets By Nation/Area

The Gulf oil producers create huge capital surpluses and invest them in a wide variety of assts all over the world - they export money used to fund everything from US Treasury bonds, equities and private credit to data centers.

Is the Gulf money export machine going to slow down? There is a possibility that it will, even if the Iran War ends soon and Hormuz opens up again. Why?

1. Spending to repair/rebuild damaged infrastructure.
2. Increased defense spending: the US has not provided an effective umbrella and the Gulf states now realize that they have to build up their own defensive capabilities.
3. They must make up the lost commodities income shortfall, amounting to some $30-40 billion so far (note: they will make it up quickly once the Strait is open AND prices stay high for a time = inflation for the rest of us).

What does this mean for global asset prices?  At the very least, the tailwind provided by Gulf money will slow down or even cease altogether.

Never Ever Mention The Market

 I hold this truth to be self evident: 

• Politicians should never, ever mention the stockmarket in their speeches.

Why? Because when doing so (always to "talk markets higher") they create the exact opposite result.  Professionals immediately interpret this as a sign of weakness and act accordingly.

The Trump administration has been waving the market flag much too often.  

• About two months ago in Congressional testimony DOJ's Pam Bondi answered a question about the Epstein files by snapping back that congressmen should instead be asking her about the record highs in the Dow and S&P.
• Yesterday President Trump adressed the Nation on the Iran War, and said "Stock prices will rapidly go back up. They haven't come down very much, frankly".

There are many more such quotes from various administration officials, some proudly mentioning Americans' 401k's as sources of increasing wealth under the Trump presidency, etc.

Bad. 

The Hidden Margin Debt

 

The latest available data puts US margin debt at an all time high of $1.25 trillion (FINRA, Feb. 2026) - see chart below.  But is this all there is, or is there additional hidden leverage? And could the part that is hidden be concentrated amongst jew a few borrowers?

Margin Debt Reported By FINRA (chart by Yardeni Research)

It is no secret that major shareholders - particularly in the tech sector - do not sell their shares to raise money since they would have to pay capital gains tax.  Instead, they borrow against their shares in the form of securiries-based lending (SBL).  Such loans basically margin debt, but they do not appear in the FINRA data since they are mostly arranged directly with private banks, domestically and abroad, and are not subject to disclosure rules. 

Nobody really knows how much money is involved in SBLs but some estimates put it at $500 billion, and perhaps more.  Therefore, the actual leverage out there is significantly bigger than what is shown by FINRA numbers alone.  Furthermore, since the equity market is currently very, very narrow and just a handful of individuals own large swaths of stock in the few stocks that make up the US stockmarket, SBL debt must also be owed by very few people (I'm sure we can all name them, but Elon Musk is a prime example with his purchase of X with loans collateralized by Tesla stock).

The risk of leverage exacerbating a market correction is always present because a margin call affects all, no matter who you may be.  

High hidden leverage + very narrow market + few individuals participating + index ETFs = ???

PS For weeks now I have observed gyrations that can be explained as "support operations" in US equity markets. Add this to the mix above...

Inflation Or Deflation?

The Iran War is causing energy prices to spike world-wide.  Energy is the most important cost element in consumer price inflation, since it effects everything from transportation, heating/cooling, fertilizers, food, chemicals, to building materials and pharmaceuticals. 

Therefore, cost driven CPI will inevitably go higher if things do not normalize in the Persian Gulf in the immediate future.

• Inflation for Goods: A spike is to be expected in consumer good prices, particularly for staple necessities such as fuels, natural gas, food and housing costs.  Let's call these "inelastic" expenses, although consumer behavior may shift after a few months of prolonged high prices (this may happen faster than before because in the US, particularly, a very large portion of households live hand to mouth and will have to cut spending even for necessities (the K-economy).

But what about assets such as equities, real estate, private credit and equity, junk bonds, precious metals, cryptos, collectibles?  Prices for these depend on spending and saving patterns by the top 10% of US households who control 80% of wealth.  How will they react to a war that drags on?  I make the following assumptions:

1. Risk premiums will re-adjust across all markets.
2. Short term interest rates may go higher, putting downward pressure on equity and precious metal valuations, on top of risk premium adjustment.
3. A squeeze in disposable income will lower discretionary spending for luxury goods and services, including travel, vacation homes, collectibles. Valuation for their respective assets will be marked down.

• Deflation for Assets: As risk appetite recedes, asset prices will be marked down.  Coming into an already highly elevated market for all risk assets, markdowns may be very substantial.  

Therefore, Inflation for consumer goods and Deflation for risk assets (if the Gulf War drags on).

One final possibility: the US may have to rework its tax policy in order to raise revenue to support the "bottom" 80% part of the K-society.  I will not be surprised to see President Trump announce a "temporary, wartime" wealth tax.  After all, the war is already costing around $1 billion per day and the tariff window has been firmly shut by the Supreme Court. Mr. Trump may, in fact, be the only President who could propose and pass such a tax (he is a populist, after all).

 The negative effect of a wealth tax on all risk assets is easy to predict, while long Treasury bonds and the FX value of the dollar may benefit.

The Danger Of “Passive Investing”

Warren Buffet is unquestionably the greatest value investor of all time. Yet, he may have unwittingly recommended the worst investment strategy to individual investors: buy and hold index funds.

It was done with the best intentions, of course, since most active money managers routinely underperform broad indexes and charge high fees. 

His advice, among others, led to a massive influx in index funds which now amount to $14 trillion in US equities alone (ETFs plus index mutual funds). That’s 25% of the market capitalization of S&P 500. 

Combine this with algo trading and we now live in a world of “passive investing” - an obvious oxymoron and the very antithesis of Mr. Buffett’s own strategy. 

Index investors trust that markets will always perform as usual. They are akin to warriors who use “fire and forget” weapons, sure that their missiles will find the target no matter what. That’s a grave mistake at a time of global fundamental changes:

1. Geopolitical power is shifting East.
2. Climate change.
3. Energy transitioning from fossil fuels to renewables challenges the dollar’s supremacy.
4. Consumer spending, and therefore GDP growth, is limited by the K-economy.
5. The US may finally deal with its fiscal problems and raise taxes, particularly by imposing a wealth tax plus a VAT-type consumption tax.

The Elephant In The Room

What made America truly great was that from its start it took tens of millions of poor, underprivileged immigrants and transformed them into a massive, vibrant and prosperous middle class which drove production and consumption to ever new highs. The Empire was built entirely upon its middle class foundation.

But starting in the 1980s ideologues took over and pushed a mantra of global free markets and, even worse, labor "deregulation" a.k.a. to destroy labor unions.  There were some positive results, to be sure.  But, in the long run production shifted to Asia, the well-paid middle class evaporated and Trump became President riding the MAGA wave - where the key word is "Again".  Judging from the explosive growth of the middle classes in China and India, "again" is just not going to happen.

Which leaves the door wide open to bitter political disappointment for the American middle class getting crushed in the K-economy.  How will they vote in the polls? And how will the current administration react to getting snubbed? 

So this is the elephant in the room, one which financial markets are not yet taking into consideration: for the first time ever there is real political risk in the USA.  It is certain that the Trump administration understands this very well.  In recent testimony to the Congressional Judiciary Committe, the Attorney General was asked a pointed question about the Epstein files.  Her immediate answer was: "you should ask about the Dow hitting 50.000 and the S&P 7.000".  In other words, everything depends on markets now. This is really scary.  

When the political agenda is guided by the gyration of indexes... watch out.

On The Risks Of Algo Trading

 Algorithmic trading now accounts for 60-80% of all equity volume in the US.  Astonishing.

I wonder... since algo trading is basically a trend following mechanism and has never been tested in a seminal bear market (algo trading accounted for a mere 10% of volume in the early 2000's and not much more during the GFC bear), what will happen if algo starts following a hypothetical down trend? 

How long will it take algo masters to throw the "off" switch during a sudden market break?  And will they then merely follow the bear all the way down, algorithmically speaking?

Mr. Warsh At The Fed

 Mr. Warsh has just been nominated as Fed Chairman by President Trump.  If he acts on his old convictions, he will be an excellent choice, in my opinion.

He was, and apparently still is, against Quantitative Easing and expanding the Fed's role in the broader economy, ie against capital misallocation to support financial markets and to raise asset prices at the expense of productive investments.  As I understand it, he is for lower interest rates AND reducing the Fed's balance sheet.  I strongly support such actions, particularly the latter.

The Fed is now sitting on $6.5 trillion of assets consisting of Treasury bonds and mortgage securities.  While significantly down from $9 trillion at the peak, it is still 600% more than 17 years ago (see chart below).

Federal Reserve Balance Sheet Assets

Some claim that such large holdings are justified because the economy has grown as a whole - but this is only partly true. As we can see from the next chart, assets are now at 21% of nominal GDP, up from 6%.  

Assets As Percentage of Nominal GDP

But even this chart is parially wrong: nominal GDP has grown significantly due to inflation, particularly in recent years.  So, a better picture can be obtained by looking at the Fed's assets as a percentage of Real GDP, adjusted for inflation (see chart below).

 

Assets As Percentage of Real GDP

Clearly, the Fed has been adding huge amounts of liquidity into the overall economy.  Some of it may be going into productive investments, but judging from the record price levels of risk assets - equities, metals, cryptos, junk bonds and spec real estate - most of it is going into pumping up their prices via easy and plentiful leverage money. Some of it is also directed to more arcane places requiring huge liquidity (eg the Treasury basis trade).  In two words: capital misallocation. If Mr. Warsh starts draining this excess liquidity, or at least stops adding to it, there will be significant consequences for all non-productive portfolio assets.  Again, two words: Main Street vs. Wall Street.  I think the rabid gold and silver speculators got the message loud a clear last Friday.

Mr. Warsh is also a champion of lower interest rates.  I have no problem with that as long as he reduces liquidity.  Under normal circumstances the Price of money is much less important than the Quantity of money. Hopefully, he will hold firm to his convictions if/when financial markets take a dive and start begging for a bailout.

As a final note, I am no great fan of Mr. Trump, but in this case I applaud his choice.

I Bid 2025 Adieu

 As we bid 2025 adieu, here is a list of what I think were the major themes of the past year and my views for the future.

• Donald Trump became President, again. The world stares in astonishment and ponders if this is how an Empire and its Emperor should act. My view?  "We live in interesting times".
• Artificial Intelligence has fired the imagination of everyone, from Wall Street to Main Street and then some. My view? The positive results will not be visible for several years yet, right now it's make hay while the Sun shines. And as far as I can tell, the technology is still at the brute force level, like using a bazooka to kill a bird.
• Precious metal prices have gone vertical, mostly because many believe they will be used as a monetary backstop. My view? There isn't nearly enough gold and silver in the world to back all the liquidity/debt in existence.  
• The US debt situation is very worrisome.  Unless the government gets its fiscal house in order by raising taxes and lowering expenses things will get really tough.  My view? The dollar's reserve status is at risk, unless..
• China is racing hard, aiming to overtake the US as the next Empire.  My view?  Not so fast, comrade - you are definitely doing well, but be a bit more patient and cautious.  Rome was not built in a day and your Coliseum may yet come crashing down.
• The US middle class - what is left of it - is getting seriously angry at its demise. My view? Mamdani in NYC is a warning shot across the bow of the 1%'s mega-yachts. 
• Climate change is real and the world will forge ahead in dealing with it, no matter what Mr. Trump says or does.  My view? Decarbonization and carbon sequestration initiatives will grow fast, creating new industries and markets.  

Wishing all a very Happy New Year!!